1. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 1 of 29 Taxes on Labor Supply 21.1 Taxation and Labor Supply—Theory 21.2 Taxation and Labor Supply—Evidence 21.3 Tax Policy to Promote Labor Supply: The Earned Income Tax Credit 21.4 The Tax Treatment of Child Care and Its Impact on Labor Supply 21.5 Conclusion

2. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 2 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y Do taxes affect labor supply?

3. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 3 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.1 Taxation and Labor Supply—Theory Basic Theory The slope of Ava’s budget constraint is now the after-tax wage.

4. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 4 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.1 Taxation and Labor Supply—Theory Basic Theory Substitution and Income Effects on Labor Supply The decrease in the price of leisure will induce a substitution effect toward more leisure and less work. A reduction in income will have an income effect that causes her to buy fewer of all normal goods, including leisure. Because the substitution and income effects on labor supply pull in opposite directions, we cannot predict clearly whether labor supply rises or falls in response to the tax. For understanding the intuition of the income effect on labor supply, it is sometimes helpful to think about an individual’s income target, his or her goal of earning a fixed amount of income.

5. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 5 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.1 Taxation and Labor Supply—Theory Basic Theory Substitution and Income Effects on Labor Supply

6. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 6 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.1 Taxation and Labor Supply—Theory Limitations of the Theory: Constraints on Hours Worked and Overtime Pay Rules Production complementarities are features of the production process that make it important to have many workers on the job at the same time. overtime pay rules Workers in most jobs must legally be paid one and a half times their regular hourly pay if they work more than 40 hours per week.

7. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 7 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.2 Taxation and Labor Supply—Evidence primary earners Family members who are the main source of labor income for a household. secondary earners Workers in the family other than the primary earners. Different responsiveness to taxes by different segments of market

8. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 8 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.3 Tax Policy to Promote Labor Supply: The Earned Income Tax Credit Earned Income Tax Credit (EITC) A federal income tax policy that subsidizes the wages of low income earners. The EITC subsidizes the wages of low-income earners to accomplish two goals:  Redistribution of resources to lower-income groups.  Increases in the amount of labor supplied by these groups.

9. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 9 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.3 Tax Policy to Promote Labor Supply: The Earned Income Tax Credit Background on the EITC To be eligible for the EITC, a family must have annual earnings greater than zero and below about $35,463, if supporting one child, or $40,295 if supporting more than one child. A family that supports no children must have earnings greater than zero and below about $13,400. For childless families, the EITC is significantly smaller.

10. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 10 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.3 Tax Policy to Promote Labor Supply: The Earned Income Tax Credit Background on the EITC

11. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 11 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.3 Tax Policy to Promote Labor Supply: The Earned Income Tax Credit Impact of EITC on Labor Supply: Theory

12. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 12 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.3 Tax Policy to Promote Labor Supply: The Earned Income Tax Credit Impact of EITC on Labor Supply: Theory This figure illustrates the impact of the EITC on four distinct groups: 1. People not in the labor force at all. 2. People already in the labor force who earn less than $11,340. 3. People already in the labor force and earning between $11,340 and $14,810. 4. People already in the labor force earning between $14,810 and $36,348.

13. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 13 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.3 Tax Policy to Promote Labor Supply: The Earned Income Tax Credit Impact of EITC on Labor Supply: Evidence

14. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 14 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.3 Tax Policy to Promote Labor Supply: The Earned Income Tax Credit Impact of EITC on Labor Supply: Evidence The literature assessing the effect of the EITC has reached several clear conclusions: Effects on Labor Force Participation There is a strong consensus across these studies that the EITC has played an important role in increasing the share of single mothers who work. Effects on Hours of Work The 1986 expansion in the EITC would have been expected to increase labor force participation, but it might also have reduced hours worked by those already in the labor force. Impact on Married Couples Although the EITC appears to have positive effects for the labor supply of single mothers, it might have negative impacts on a married couple ’ s labor supply decisions.

15. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 15 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 21.3 Tax Policy to Promote Labor Supply: The Earned Income Tax Credit APPLICATION  EITC Reform While the EITC has been a major success story, there are significant flaws in its design:  There is only a very small EITC for childless workers, with a maximum of only $412 per year.  Families receive no additional EITC transfer as family size grows beyond two children.  It penalizes many single parents who subsequently marry because the credit is based on the income of the tax filing unit. Not all marriages are, however, penalized by the EITC:  Take the case of a single mother with two children and no income. If she marries a man whose annual income is $12,000, then together they qualify for the maximum credit of $4,536, even though on her own she would not receive any credit. 

16. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 16 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y Conclusion 21.5 If higher taxes lead people to change their behavior to supply less labor, these changes can offset the gains from tax increases and there might be a natural limit to the revenue that can be raised by income taxation. Most studies show that tax rates have little impact on the labor supply of primary earners but a more substantial impact on secondary earners. We reviewed one of the major tax policies to promote labor supply, the Earned Income Tax Credit (EITC), and discussed evidence showing that the EITC has raised the labor supply for low-income earners. Finally, we discussed the appropriate tax treatment of child care.

17. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 17 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y Taxes on Savings 22.1 Taxation and Savings— Theory and Evidence 22.2 Alternative Models of Savings 22.3 Tax Incentives for Retirement Savings 22.4 Conclusion capital income taxation The taxes levied on the returns from savings.

18. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 18 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y

19. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 19 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.1 Taxation and Savings—Theory and Evidence Traditional Theory intertemporal choice model The choice individuals make about how to allocate their consumption over time. savings The excess of current income over current consumption.

20. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 20 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y A Simplified Model 22.1 Taxation and Savings—Theory and Evidence Traditional Theory 1+r= interest earning 1- t = tax rate

21. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 21 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y A Simplified Model 22.1 Taxation and Savings—Theory and Evidence Traditional Theory intertemporal budget constraint The measure of the rate at which individuals can trade off consumption in one period for consumption in another period. The opportunity cost of first-period consumption is the interest income not earned on savings for second-period consumption.

22. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 22 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y Substitution and Income Effects of Taxes on Savings 22.1 Taxation and Savings—Theory and Evidence Traditional Theory The price change that results from the tax on savings interest will have two effects:  The lower after-tax interest rate will cause consumption in period one to rise through the substitution effect. This will in turn lead savings to fall.  There is also, however, an income effect of lower after-tax income. When thinking about the income effect of changes in the after- tax interest rate on savings, it is helpful to reflect on the extreme case of a target level of consumption for retirement in period two. If Jack has a certain amount of consumption he wants in period two, then when the after-tax interest rate falls, he must save more and reduce C W in period one to achieve that target.

23. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 23 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y Substitution and Income Effects of Taxes on Savings 22.1 Taxation and Savings—Theory and Evidence Traditional Theory Intertemporal Substitution vs. Income Effect If the substitution effect is larger than the income effect, individuals will move from point A to point B, consuming more in the first period (C W 2 ) and thus saving less (S 2 ). As a result, their consumption in period two (C R 2 ) falls by a lot.

24. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 24 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y Substitution and Income Effects of Taxes on Savings 22.1 Taxation and Savings—Theory and Evidence Traditional Theory Intertemporal Substitution vs. Income Effect If the income effect is larger, individuals will move from point A to point C, consuming less in the first period (C W 3 ) and thus saving more (S 3 ). Their consumption in period two (C R 2 ) still falls, but not by as much.

25. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 25 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.1 Taxation and Savings—Theory and Evidence Evidence: How Does the After-Tax Interest Rate Affect Savings? Studying the connections between after-tax interest rates and savings is a difficult problem. Although we can measure a given worker ’ s wage, it is hard to measure the appropriate interest rate for any given saver. The interest that can be earned on any type of savings typically changes over time in the same way for all individuals, making it hard to find appropriate treatment and control groups for studying how savings respond to interest rate changes.

26. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 26 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.1 Taxation and Savings—Theory and Evidence Inflation and the Taxation of Savings Before 1981, the tax brackets on which taxation is based were denominated in constant dollars that did not change with inflation. This practice led to a phenomenon known as bracket creep, whereby individuals would see an increase in their tax rate despite no increase in their real income.

27. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 27 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.1 Taxation and Savings—Theory and Evidence Inflation and the Taxation of Savings Inflation and Capital Taxation nominal interest rate The interest rate earned by a given investment. real interest rate The nominal interest rate minus the inflation rate; this measures an individual’s actual improvement in purchasing power due to savings.

28. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 28 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.1 Taxation and Savings—Theory and Evidence Inflation and the Taxation of Savings Inflation and Capital Taxation

29. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 29 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.1 Taxation and Savings—Theory and Evidence Inflation and the Taxation of Savings Inflation and Capital Taxation We can define the relationship between the real and nominal interest rates as: Real interest rate (r) = [1 + Nominal interest rate (i)] / [(1 + Inflation rate ( p )] – 1 The problem is that taxes are levied on nominal, not real, interest earnings.

30. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 30 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.2 Alternative Models of Savings Precautionary Savings Models precautionary savings model A model of savings that accounts for the fact that individual savings serve, at least partly, to smooth consumption over future uncertainties. liquidity constraints Barriers to credit availability that limit the ability of individuals to borrow.

31. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 31 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.2 Alternative Models of Savings Precautionary Savings Models Evidence for the Precautionary Model Studies have shown that more uncertainty leads to more savings, and that reducing uncertainty reduces savings. Other studies have shown that expansions in social insurance programs that lower income uncertainty also lower savings.

32. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 32 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.2 Alternative Models of Savings Self-Control Models In this model, a key determinant of savings behavior is the ability of individuals to find ways to commit themselves to save, so that they can keep their income out of the hands of their impatient “ short-run self. ” Evidence for the Self-Control Model Individuals with self-control problems will demand commitment devices to help curb their self-control problems. A classic example is the “ Christmas club, ” a bank account into which individuals put money throughout the year, at low or no interest, to make sure they have money available at Christmastime to buy gifts.

33. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 33 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.3 Tax Incentives for Retirement Savings Available Tax Subsidies for Retirement Savings Tax Subsidy to Employer-Provided Pensions pension plan An employer sponsored plan through which employers and employees save on a (generally) tax-free basis for the employees’ retirement. defined benefit pension plans Pension plans in which workers accrue pension rights during their tenure at the firm, and when they retire, the firm pays them a benefit that is a function of that worker’s tenure at the firm and of their earnings. defined contribution pension plans Pension plans in which employers set aside a certain proportion of a worker’s earnings (such as 5%) in an investment account, and the worker receives this savings and any accumulated investment earnings when she retires.

34. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 34 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.3 Tax Incentives for Retirement Savings Available Tax Subsidies for Retirement Savings 401(k) Accounts 401(k) accounts Tax-preferred retirement savings vehicles offered by employers, to which employers will often match employees’ contributions. Individual Retirement Accounts Individual Retirement Account (IRA) A tax-favored retirement savings vehicle primarily for low- and middle-income taxpayers, who make pre-tax contributions and are then taxed on future withdrawals.

35. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 35 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.3 Tax Incentives for Retirement Savings Available Tax Subsidies for Retirement Savings Individual Retirement Accounts For low- and middle-income households, IRAs function as follows:  They are not a special type of savings. Almost any form of asset can be put in an IRA (from stocks to bonds to holdings of gold).  Individuals can contribute up to $5,000 tax-free each year (deducted from their taxable income).  Unlike the interest on a regular savings account, the interest earned on IRA contributions accumulates tax-free.  IRA balances can’t be withdrawn until age 59 1⁄2, and withdrawals have to start at age 70 (or there is a 10% tax penalty).  IRA balances are taxed as regular income on withdrawal.

36. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 36 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y Keogh accounts Retirement savings accounts specifically for the self- employed, under which up to $44,000 per year can be saved on a tax-free basis. 22.3 Tax Incentives for Retirement Savings Available Tax Subsidies for Retirement Savings Keogh Accounts

37. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 37 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.3 Tax Incentives for Retirement Savings Why Do Tax Subsidies Raise the Return to Savings? With tax-preferred retirement savings, you get to hold on to any taxes you would have paid on both your initial contribution and any interest earnings, and you get to earn the interest on the money that would have otherwise been paid in taxes.

38. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 38 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.3 Tax Incentives for Retirement Savings Theoretical Effects of Tax-Subsidized Retirement Savings

39. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 39 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.3 Tax Incentives for Retirement Savings Theoretical Effects of Tax-Subsidized Retirement Savings Limitations on Tax-Subsidized Retirement Savings

40. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 40 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.3 Tax Incentives for Retirement Savings Theoretical Effects of Tax-Subsidized Retirement Savings Limitations on Tax-Subsidized Retirement Savings Low Savers vs. High Savers Mr. Grasshopper saves little before the IRA is introduced (point A), consuming C W 1 and saving only $1,000. For Mr. Grasshopper, the effect of the IRA on savings is ambiguous: if substitution effects dominate, he will move from point A to point B (with savings rising); if income effects dominate, he will move from point A to point C (with savings falling).

41. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 41 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.3 Tax Incentives for Retirement Savings Theoretical Effects of Tax-Subsidized Retirement Savings Limitations on Tax-Subsidized Retirement Savings Low Savers vs. High Savers Ms. Ant was a high saver before the IRA was introduced, consuming C W 1 and saving $6,000 (point A). For Ms. Ant, the introduction of the IRA does not change the price of first–period consumption, but it does have an income effect, causing her period–one consumption to rise to C W 2 and her savings to fall to S 2, $5,000.

42. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 42 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.3 Tax Incentives for Retirement Savings Implications of Alternative Models Precautionary Savings Asset reshuffling will be likely if two conditions are met: if a large share of IRA contributors would have saved $5,000 anyway in the absence of the IRA, and if IRA savings and non-IRA savings are viewed as highly substitutable. Self-Control Models Retirement accounts such as pension and 401(k) accounts provide excellent commitment devices because the contributions are taken directly out of the paycheck and individuals can’t access their money until retirement.

43. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 43 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.3 Tax Incentives for Retirement Savings Evidence on Tax Incentives and Savings Evidence from recent studies suggests that individuals do respond to these savings incentives by saving more—and might even respond enough to raise not only private but national savings. Several studies suggest that it is not tax savings but other factors in program design that have the most impact on the effect of retirement incentives. These types of findings have motivated President Barack Obama’s recent plans to reform our retirement savings system.

44. Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 44 of 29 C H A P T E R 2 1 ■ T A X E S O N L A B O R S U P P L Y 22.4 Conclusion One of the most important decisions made by taxpayers in the United States is how much to save, and it seems likely that taxes factor into that decision. Neither theory nor existing empirical evidence offers a clear lesson for the magnitude (or even the direction) of the effect of taxes on savings. In 1975, the tax expenditure on incentives for savings was less than $20 billion; in 2006, it had grown to $105 billion. Clearly, policy makers believe that tax incentives can make a difference in the savings decisions of individuals. Are more savings instruments needed? What can be done to encourage more savings?